“How can these be reconciled?” asked Wells Fargo’s John Silvia in a research note today.
“Two factors explain the conundrum,” he answered. “First, as shown in the bottom graph, auto loan rates are at historic lows for the 48-month new car loan. Second, the asset-backed security market has become a prime source of credit for auto purchases.”
That latter point is important because many people will cringe when they hear “asset-backed securities,” or ABS. Going into the financial crisis, ABS were the investment vehicles that fuelled the proliferation of sub-prime mortgages by adding tremendous amounts of liquidity to the credit markets.
Simply put, here’s how ABS work: 1) a bank will issue a loan to a borrower, 2) the bank will then sell that loan to an investment bank, 3) the investment bank will package (or securitize) that loan with other loans creating an ABS, and 4) the investment bank will then slice up the ABS and sell them like bonds to investors all around the world.
There are two benefits to the ABS process: 1) it frees up bank capital so that they can lend more and 2) it gives investors around the world access and exposure to more types of bonds.
“This development reflects two aspects of the credit markets that survived the recession,” said Silvia. “First, the globalization of credit markets as much of the ABS paper is sold to foreign investors who are seeking higher yields with a degree of safety. Second, securitization of credit remains a viable means of financing economic activity despite negative commentary on securitzation in recent years.”
The ABS industry got a bad rap during the financial crisis for being associated with sub-prime mortgages. But with transparency, it’s pretty clear to see how ABS benefits everyone.